Some of the risk
management tools that
investors have embraced
to try to avoid a repeat
of 2008 could end up causing
more harm than good.
By Max Stone, Daniel Michalow and Trey Beck
illustration by maxwell holyoke-hirsch

and they are a function of only one form of information — price. This article examines four investor
behaviors that. the result is the same:
Measures taken to solve one problem can exacerbate that very problem or cause others. More important. stop losses don’t take into
account other risks in a portfolio. and simplicity is a virtue. “stop losses are good” is a poor lesson
to take away from the last crisis.S. with the Federal
Reserve estimating losses of more than $11 trillion in the U. is short
the Taiwan dollar by the same amount and has 5 percent stop losses
on both positions. Examples abound. these stop-loss currency trades were similar to equity
market sell orders filled at the lows that day. That hurdle arises
for two reasons: Stop losses are set in advance. Given the potential stakes. Stop losses.This naturally puts the spotlight on risk management. let’s consider a real-world example. both because of their original trade thesis — in
some cases. Although the “flash crash” started
in equities. exactly? It’s a regime that mandates. some important exceptions are worthy of discussion. buying options. (This concept can be applied at a variety of levels. Let’s also assume that the fund manager doesn’t
have a view on Asian foreign exchange overall and therefore has put
on these positions at the same size in an effort to hedge regional risk. the later reduction
or elimination of that position if a predetermined loss threshold is
breached. In our view.
We believe that stop losses are generally ineffective as a risk management tool and thus almost never use them. negative externalities. and the 5 percent stop loss consequently
will be triggered. another
2 percent on Tuesday and 1 percent on Wednesday.To
illustrate the potential pitfalls.The price movements that
triggered the stops reverted almost immediately. On March 17 the yen plunged
3. Most investors that
sold Procter & Gamble Co. it appears they have learned some
very good ones. relying on other
solutions instead.
On the afternoon of May 6.
By the very nature of their simplicity. Nonetheless.
Have market participants learned the right risk management
lessons from 2008? In many cases. And most of those currency liquidations. this sounds like a tempting solution for stopping losses. perverse incentives.
which interpreted the equity sell-off as a “risk off!” signal.8 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 7
The idea
goes by
different
names —
unintended consequences. as the
name itself implies.
Stop-loss constraints have received an unusual amount of attention in the past couple of years as investors rattled by 2008’s severe
losses have asked themselves how they could avoid a repeat performance.The Brazilian real weakened by 5 percent against the U. Recent performance appears to lend credence to
the idea.The stops hit when people didn’t
really want to get out. then rebounded within a few hours. to our mind. leaving the portfolio riskier than it was
before the stop loss kicked in. A trader can try to mitigate this problem by setting stops on
groups of positions.This means a lot of other crucial market dynamics are
ignored.This property of stop losses is an important limitation because fund managers
ultimately care about portfolio performance. were
awful outcomes for those affected. stress
testing and crowding into certain trades. alone
that year.The fund really
hasn’t made or lost any money — losses on the South Korean won
will be matched by gains on theTaiwan dollar. There are many other
examples. Normally. What is a stop loss. However. the positions were becoming fleetingly more attractive
— and because there was virtually no liquidity (meaning that there
were unusually high costs of execution). it’s useful to consider whether
some of the key steps that investors have taken in the past two years to
protect themselves against the next financial crisis may do more harm
than good. Consider an admittedly extreme example. shares when they were down 50 percent
during the flash crash probably didn’t want that outcome.
Stop-loss protocols are simple. from
individual positions to specific traders or business units.S. macro funds and commodity trading advisers
(CTAs). from the ability of infections
to resist drugs to new roads that result in more congestion to forms
of insurance that encourage dangerous behavior. reflect a fundamental misreading of
the last financial crisis: relying on stop losses.The problem is that the book
is now short Asian currencies.S.
moral hazard — but regardless of what it is called. but he or she cannot escape it entirely. 2010. forcing a sale to cut risk. Investors are paying more attention to tail risks. dollar while the Australian dollar
dropped 9 percent relative to the yen.
The above example illustrates that stop losses may help limit losses
on a particular position but they don’t necessarily limit losses on the
portfolio. however. and they are appropriately more skeptical of reliance on
third parties like rating agencies.
. it turns out. dollar in a matter of minutes because of
stop outs. the Dow Jones industrial average plummeted 573 points in a matter of minutes. An unprecedented
amount of household wealth was destroyed in 2008. Of note more recently is trading in the Japanese yen a few
days after the Tohoku earthquake.5 percent against the U. they
are more conscious of the need to carefully manage liabilities as well
as assets. For example. outperformed in 2008. Riskier
positions in emerging-markets currencies and popular currency
carry trades began hemorrhaging money.
Now imagine that Asian currencies sell off and that the won and
Taiwan dollar perform similarly: down 2 percent on Monday. not position performance. It’s noteworthy that a large
fraction of the currency trades executed during the flash crash were
stop outs. But
this simplicity comes at a price because stop losses require trading
on the basis of stale or incomplete information. only to recover
most of that loss just as quickly. the won
position shows a large loss. in
advance of entering into an investment position. don’t allow for such reasoning.
In a sense. when investors think about a trade and look at
recent market data.) On the surface. but
their execution tactics left them vulnerable. which tend to use stop-loss mechanisms more than other
hedge fund strategies. which accounts for
the staleness. Suppose that a macro fund’s currency portfolio has a $100 million long position in the South Korean won. these
behaviors are at best inefficient from a trading perspective and at
worst could cause substantial trading losses regardless of whether
markets themselves are behaving normally. the panic immediately spread to the currency markets.That’s a big deal. they try to understand what’s driving a given
asset price.

There are other stop-loss implementation problems as well.
Now. but it’s
important to remember that managing risk is not just about putting
guardrails around trades or even portfolios.
in the real world. Similarly. giving a stop-loss order
to a dealer not only reveals the price at which one is willing to exit the
position. but effective. whereby a trader leaves the
stop order with a trading counterparty.Yet we know that some very
successful firms use stop losses. Rather than apply an inflexible rule to all positions if they
suffer some prespecified drawdown. And there’s typically no
guarantee that an investor will actually get out at the stop loss. Simple.
swap spreads. particularly when a position is large relative to the market
or when a trade is crowded and multiple investors get stopped out
simultaneously. So what do we propose instead?
information. we think it’s our job to try to be just that.
This reservation highlights an important illusion about stop
losses: They are built on the assumption that at the stop point it’s
possible to trade out of a losing position at reasonable cost and
thereby avert a lot more damage.
triggering of stops greatly exacerbated a huge move in ten-year U.
When viewed purely on the economic merits. Of course. it’s also about encouraging responsible behavior. we might look to increase
the size of the trade. as a side note. If the fundamentals have not changed but
the price moves against us nonetheless. we believe that much of the critical risk management
function must be carried out when one is initially researching a trade. they foster a binary mind-set:
“If I haven’t hit my stop loss.Treasury bonds and interest rate swaps — are
two of the most liquid in the world. For example.
especially with their most extreme form (used more widely by
smaller funds and individual investors). if I’ve hit my stop
loss. But rather than
give up hope that we can be rational and disciplined in the face of new
Managing risk is not just about creating guardrails around
trades.This assumption often doesn’t hold. A
two-day momentum forecast. a large adverse price move may signal increased risk. only
that the order will kick in at that point. If the price moves for a reason unrelated to our
forecast. Stop losses can
promote a number of unhelpful behaviors.
then we would liquidate the position.We think it’s an
overreaction to outsource this decision to a simple price-based rule. that concerns about realistic liquidation assumptions are
limited to smaller. we need to move outside the bounds of portfolio
management logic and consider principal-agent relationships within
investment firms. After all.
in which case we would tend to downsize the position. this
is unlikely to produce good results. It is simply untrue.The practical upshot
of this is often that we just put on a smaller position than we likely
would if we used stop losses. and we then size positions at the outset by assuming that
some of the worst of those outcomes may occur and that downsizing
may not be possible except at prohibitive costs. it’s easier to be nimble when responding to bad outcomes if you’ve been reasonable about the number of positions that
your portfolio holds. a stop-loss proponent might argue that the approach we’re
advocating is undisciplined and affords much wiggle room for a crafty
trader to rationalize a bad investment all the way to zero.These stop losses were unfortunate. yet they moved significantly
(and. stop-loss strategies
seem to have little to recommend them. It’s true that
the human tendency to indulge in “thesis creep” is real. stop losses can inflict substantial
damage.”
Traders may rely on their stop losses to knock them out of a losing
position. we evaluate the utility of the position
dynamically and in the context of the current set of available facts. It’s just
that they are less encouraged to do so by the apparent safety afforded
by a stop-loss program.S. I must reduce or eliminate the trade. but also cedes control of the order.
therefore.To get our heads around the wide popularity of stop losses. we try to anticipate an array of
possible bad outcomes and the specific circumstances that might
cause them. it’s widely believed that in March 2010 the
For starters. the trade’s still okay. A substantial portion of the realized loss apparently resulted from transaction costs
associated with liquidating such a large position. But
such cases are a minority.m ay 2 0 1 1
institutional investor
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asset management
Stop losses are often promoted as sound risk management.
What do we do when a position goes against us? There are a few
scenarios to consider. For example.
In addition. If we’re wrong and the trade loses
money because our fundamental forecast turned out to be incorrect. It’s also about creating
structures that encourage responsible behavior.
What’s especially remarkable is that the specific instruments at issue
here — ten-year U. very visibly in public policy circles) as a result
of a concentrated burst of stop-loss unwinding. As an execution tactic. we tend to run our fundamental
(as opposed to systematic) portfolios with a manageable number of
positions so that we can make informed decisions when interesting
news hits or prices move.The main point here is that. so that our go-forward forecast is the same.S. less-liquid markets. prices will tend to go against us for several of the
above reasons. to avoid continually reassessing the risk-reward merits of
the position.
Even in the most-liquid markets.
however.We believe the trade
would have made a modest profit if these stops had not been tripped.
We have now discussed in detail why we rarely employ stop losses
and why we don’t give credence to some of the arguments used to
defend them.This isn’t to say traders
using stop losses won’t necessarily conduct such analyses. In addition to those forecast
considerations. risk overseers will tend to allow positions to
run if they haven’t hit their stop losses. Certain
quantitative trend-following models widely employed by CTAs
effectively incorporate stop losses into the investment thesis itself. we would generally maintain the position size.
. even if that’s not the right
thing to do given changing market conditions. in contrast to the robotic
nature of a stop-loss regime.
This is vital. has an implicit stop loss
after a given instrument loses money for two consecutive days. How did such an inefficient trading
practice gain such a wide following? Are we missing something?
In some contexts there’s an internal logic to stop losses. In short. for example. often through complacency borne of a sense that these safeguards will do much of the risk
management heavy lifting.

Under these
conditions it may be rational for traders to
impose (or willingly have imposed on them)
stop losses on their individual positions to prevent a reduction in earnings potential or the
career risk that can result if too many of their
investments suffer significant drawdowns. instrument
Y. for instance.
ANOTHER STRATEGY THAT some
managers and investors have offered as
a way to avoid large. Why? We believe two factors relating
to principal-agent dynamics may be at play.
which is a meaningful risk negative.
Second.
Options are also not the most efficient way
to express a directional trade view.
The most significant problem with
expressing directional views using options is
that their exposure to the underlying instrument varies over time.
Suppose a trader has a view that the
exchange rate for the euro will go from
$1. Often those individual traders are also monitored by a
centralized risk management group.
Unfortunately. Another way to
think about this is that the ultimate payoff
will be very sensitive to which option strike
price is chosen. given the potential penalties for
exceeding risk limits. there’s a bet on the volatility of the
underlying security because the price of
the option.
First.
a single trade) and thus may fail to capture
important portfolio dynamics. “Buying options allows us to structure
asymmetric bets with limited downside and
unlimited upside and.40 to $1.
which is a significant benefit for risk-averse
investors. as computed using standard option models.The typical argument
for buying options focuses only on the terminal up-and-down scenarios and ignores
the path to those final outcomes. needs some serious explanatory support. if breached. this option implementation
introduces two side wagers that are not part
of the original forecast. interest
rates and. suppose the
trader instead buys $500 million of notional
exposure to euro call options that have a 20
percent delta (meaning the option gains in
value by 20 cents for each dollar increase in
the underlying).
First. even though the basic
directional forecast was correct. the trade as implemented will lose
(because the options will expire worthless
out of the money). although the price of an option is obviously directly related to the performance of
the underlying instrument. Siloed firms may have dozens of
individual traders running separate books
that in the aggregate contain a multitude
of positions across numerous asset classes. Rather than
buying $100 million in cash euro.
• They implicitly (and often very wrongly)
assume that future trading activity can be
accomplished. the options implementation
introduces an added and critically important timing component. in the case of stocks. we’ve
noticed considerably greater interest in this
risk management technique since 2008.
• They operate in isolation (on. This balancing act is typically
implemented through a strict “eat what you
kill” policy whereby traders are compensated
solely based on a percentage of the profits
from their trades and by imposing stop losses
that. the effective
exposure to the euro.
The argument here usually goes something
like. however. depending on the path the
euro took to get to that price. Perhaps
$1. Here the risk manager uses
stop losses to fulfill his or her duties in the
most reasonable and effective manner possible given the firm’s decentralized structure. Because the trader chose a $1. So when it comes to
implementing individual trades by buying
options. If the trader’s profit-loss fluctuations are unexpectedly large and it would take
a lot of time to understand why. and at a reasonable cost.
Under these conditions it may be virtually
impossible for a centralized risk manager to
know exactly what a given trader is doing all
of the time. the practical benefits of
asymmetry begin to wash out as the number
of positions increases. but the trade could well
have lost money. is a
function of that volatility. we’d rather see
our investments work out quickly).
Let us briefly recap why we think stop
losses are not the answer to a year like 2008:
• They are set in advance and based solely on
price movements.
although the asymmetry offered by options
is a nice risk property. by doing so. Although timing
always matters (all else equal. it might be
reasonable for the firm to implement a “shut
it down and ask questions later” approach
using stop losses. Stop
losses tend to be more popular among siloed
firms. is about $250 million. For one
thing. such as volatility.This directional view could
be implemented simply by buying the euro
or euro forwards. Or the trader could instead
buy unhedged euro call options. One important factor mitigating
that benefit.
Principals at siloed firms seek simultaneously to motivate and discipline their traders.To summarize.50.
their employment terminated. they also introduce
volatility.46 three-month calls would do the trick.
• They may create a false sense of security
about trading positions.
. avoid the
potential large losses we might suffer in an
outright position.and timing-related uncertainty.
To begin with. is that the payoff profile only matters to the extent that it applies
to the entire portfolio. 2008-like losses is to
express trading views using option contracts. timing is
vital with options given their expiry feature. a siloed firm may use stop losses to
impose order in a centralized or top-down
fashion.” As with stop losses.46
strike price to generate a more asymmetric
payoff. dividends.
Second. Suppose the trader’s bullish
euro view is correct and the currency goes to
$1. worse. Now imagine that the euro goes quickly
from $1. at least close to inception.46.
That entails balancing opportunity and profit
incentives against limitations designed to prevent an individual from taking so much risk
that it threatens the firm’s overall profitability
or solvency.
It’s great that the trade is profitable so far. it may be rational for
traders to impose stop losses themselves. will result in traders having
their risk allocations pared back or.40 to $1.
the fundamental insight would have been
directionally right. Consider
the previous currency example. For all but the largest
individual trades.
If the above positive forecast on the euro was
realized over six months but the trade was
implemented using three-month options. the benefit to the end investor may
not be all that significant. any argument that one
should implement a view on instrument X
by trading a different security. so they demand trading
activity that may prove irrational or destruc-
tive after subsequent or nonprice market
information becomes available.45 (in the right direction but not all the
way there). it’s also affected
by other factors.
It’s true that option payoffs are asymmetric. thereby
structuring an asymmetric payoff. so that the exposure to the
euro at the trade’s inception is also $100 million. so it’s
worth scrutinizing this claim in more detail.
This is an important point.8 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 7
Some investment funds or proprietary
trading desks employ a strictly siloed structure in which traders or business units operate relatively independently after receiving
an allocation of capital. Suddenly. consider the following example.

The problem. The skewness of options
makes them particularly useful for hedging
against crash events. particularly as this risk management
practice gains more adherents. while we have argued against
the implementation of most directional
views using options.
To be clear.)
We also use out-of-the-money options as
portfolio hedges.
This is a general property of implementing a
directional view by using options:The effective economic exposure to the underlying
instrument will tend to grow when it would
be better for it to shrink. “We can only work on precedent. But we also think that
leaning too heavily on narrow stress testing
entails certain risks that should be borne in
mind.
This is true even if we ignore the previously
mentioned timing and volatility uncertainties
that options introduce. as riskaverse investors.
• Option strategies have the perverse fea. One of the risk manage-
crises.This means that the volatility of this implementation is higher than the
volatility of the direct implementation and
that therefore the options implementation
has a lower Sharpe ratio. the risk of losing financing on an asset
purchased with borrowed money. it may become a more attractive
investment and thus deserving of increasing. Similarly. is that investors
often overfit to the recent past.We believe in the value of stress
tests and conduct them as part of our risk
management process.m ay 2 0 1 1
institutional investor
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asset management
but from a risk management standpoint.
The main complement toVaR modeling is
more-extensive and more-sophisticated stress
testing. options markets typically are far
less liquid and have higher transaction costs
than markets for the underlying securities.
Crises reinforce the idea that VaR is nice
but insufficient for two reasons.”The engineers
involved discounted the possibility of such
a large tsunami because they hadn’t seen
one before. in every crisis some set of factors
that had not been known to carry unusual
risk takes center stage and makes that crisis
unique relative to previous events. we do think it’s appropriate to use
options for implementing views on options. we want to hedge.)
Moreover.
• In practice. we worry that investors are stress testing based on scenarios that
are overly specific. Consider
as an example 2008’s funding risk — that
is. That people are doing more of this
now is in many ways a good thing. Investors
typically underappreciate risky scenarios
that haven’t previously occurred and worry
too much about specific bad outcomes that
have occurred most recently. for example). using options is expensive. though.
Because the recent financial crisis is so
fresh and was so painful.This shouldn’t have been news. the payoff structure of an option can
be replicated by dynamically trading the
underlying instrument. “What would have
happened to this current portfolio in 2008?”
(We’re routinely asked exactly this by investors and consultants. In the first case. and recently the
concept has even been extended to nuclear
power plants.
• Options are often less liquid and involve
higher transaction costs than the underlying
securities.
and there was no precedent. So we can compare
holding the instrument to maturity over one
year against dynamically trading it over the
same period (which is equivalent to buying an
unhedged option).
the position is now more than double its
initial size. (In other
words. As a former
director of the Fukushima Daiichi nuclear
power plant said after Japan’s recent earthquake.The intuition behind
this math fact is that under the standard
assumptions of the Black-Scholes pricing
model. but we don’t believe portfo-
. oil spikes and so forth — that are unlike
the most recent past thatVaR captures. because of their volatility
risk premium. and vice versa. The simplest example of
this is a tendency to ask. As a
trade moves favorably and approaches the
target price. liquidation
ture of increasing exposure to a trade as it
approaches a trader’s theoretical target price
and decreasing that exposure as the trade
moves away from the trader.
in the latter dynamic sizing case (equivalent
to owning a call option). the asymmetries that are obvious at the level of an individual option position often largely disappear in a broader
portfolio of such positions. We frequently use them when
seeking to exploit apparent inefficiencies
in the volatility markets.
ment truths reinforced by the events of 2008
is thatVaR methodologies by themselves are
not enough.
STRESS TESTS HAVE BEEN ALL the
r age since 2008.
Additionally.)The answer is certainly
worth knowing. that places limits around
portfolio volatility. additional noise is
introduced because of the way the size of the
trade fluctuates.
To recap our concerns with the post-2008
infatuation with options-based directional
investments:
• Incorporating options into an investment
position can muddy the waters by introducing additional forms of risk (volatility and
timing.
but markets hadn’t experienced a major crisis for quite some time. And note that the size increase
has occurred as the price of the underlying security has moved closer to fair value. volatility increases and correlations change in a
crisis.S. Investment
managers should worry about how their portfolios will perform in highly risky but plausible
Investors typically underappreciate
risky scenarios that haven’t previously
occurred and worry too much about bad
outcomes that have recently occurred.
Second. First. this means that precrisis VaR fails as
a predictor of realized crisis performance. or VaR. we think options can be
wonderful instruments for certain investment ends. as a position
moves away.
They’re costly to buy. and European banks. (Implied volatility is typically
higher than expected future realized volatility. it’s often prudent for a trader
to reduce the position size given that there’s
less juice left in it.They’ve been conducted on
U.
A standard approach to risk management
typically includes some form of value-at-risk
analysis. relative to underlying instruments. our forecast over a certain time period is expressed by
holding the instrument over that time period.scenarios — stock market crashes. some of which we
believe occur because of trading activity
much like that described above.
It’s worth noting that the above property
on its own is sufficient to prove mathematically that using options to implement investment views yields a lower Sharpe ratio than
relying directly on the underlying instrument. about which the trader
may have no opinion or insight. which are discontinuous and produce portfolio tails that.

happened all over again.
What does “if 1 998 happens today” even
mean for these instruments? Such stress tests
are also not realistic. in that portfolios do not
remain static over specific periods. 2018.
A risk model that is too narrow can easily be
tricked or sidestepped by risk-takers.4 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 01 02 03 04 05 0
lios should be managed to parameters defined
by that analysis. if the 2008 risk management
failure is now generally agreed to have been
the result of an overreliance on VaR modeling. we think investors should incorporate 2008 risk in their risk
model but not overfit to it. our chief
risk officer.
An example of overfocusing on 2008 is
the Basel Committee on Banking Supervision’s proposal that banks include a
“stressed value-at-risk” measure in certain
calculations of market risk in bank trading books. we’re confident in predicting that the next liquidation crisis will
always differ from the last one in important
respects. having learned some painful
lessons from fixed-income trading losses we
sustained in 1998 following the collapse of
hedge fund firm Long-Term Capital Management. The model also distorts the
portfolio by skewing it away from a scenario
that is unlikely to repeat itself. such as
1998–2008.
More specifically. New
products appear. the world will tend to change in
ways that make recent bad experiences less
likely to repeat themselves.We also
try to put error bars on these calculations. either
intentionally or unintentionally.We try to test
a portfolio based on a wide and changing set
of scenarios in which the performance estimates reflect what might happen if a certain
scenario occurred in today’s market. for at least a few reasons.VaR
and standardized stress tests are popular
because they are objective. In our experience. and it
will likely deter banks from taking the risks
that hurt most in the recent crisis rather
than the risks that will hurt the most in the
average or next crisis. We have investigated past specific
scenarios such as “If LTCM blew up today. We appreciate that the task of the Basel
Committee and other regulators is not an
easy one. rules and regulations
evolve. If 13 years from now we’re still
conducting stress tests based on 2008. The plan envisions calculating
this risk based on a recent period of market
stress. particularly in the presence of
agency issues (regulator versus bank or risk
manager versus trader).
precisely because of how much pain investors
and financing providers alike experienced
when credit evaporated.what are
the consequences?Will the results look as inapplicable as a “1998” stress test seems today?
To paraphrase Peter Bernard.
situation. 2010 (pulled from a hat). capitalize themselves more
robustly and reduce counterparty risk. For many applications. risk management practices. say. For the present
of its credit default swap) of the magnitudes
seen in 2008 during a crash in. the failure in the next crisis may be a
reliance on overly specific stress testing. although it’s good for regulators
to make changes to prevent 2008 from happening again.
Overall. obtain moresecure funding. Some instruments weren’t
around in 1998. suppose an investor is
allowed to own any portfolio so long as he
or she would not lose more than $10 million if.
how would our portfolios do?” This is a difficult exercise because it’s not easy to know
precisely how to apply that specific set of facts
to today’s markets. and some relative relationships have
inverted signs today (the 30-year swap spread
turned negative in 2008). and it’s clear what
incentives it produces. A
statement that a portfolio is expected to lose
$100 million in a given event will generate
a very different risk management outcome
than a statement that a portfolio is expected
to lose $100 million plus or minus $1 billion. that will be
March 2008 through March 2009. So
managing to a highly specific past scenario
can be bad because it permits “arbing the risk
model” and because it has characteristics that
are less likely to recur. To take an
extreme example. These risk models
are also relatively easy to implement. Regulatory constraints. macroeconomic forces shift.
It’s a general risk management principle
that one should worry about a range of
risks and try to use a diverse set of broad
hedges when attempting to mitigate them.To be clear. But we should
not delude ourselves into thinking that stress
scenarios based on what happened in 2008
will alone protect us in the next crisis. it’s likely they will spend too
much time and resources fighting the last
war. because the world changes.
• Stress tests may create a false sense of security unless they are sensitive to the dynamic
.
But we believe that a broader and more
subjective approach is called for.
not without enormous cost). some of those that were are at
vastly different levels today (two-year interest
rates have gone from 6 percent then to about 1
percent). yet building a regulatory regime and
corresponding hedges around the most recent
crisis could blind banks to non-2008 risks or
create incentives to take on disproportionate
exposure to new or emerging risks that don’t
fit the 2008 model.
• Stress testing based on the last crisis may
create perverse incentives by allowing risktakers to pile on a host of risks — just not those
characteristic of the most recent precedent.
The next financial crisis will necessarily
differ from the last one because the
world will change to avoid the major
problems of the recent past. It
would be very surprising to see moves in
the cash-CDS basis (the difference in price
between the cash price of a bond and the price
We can speak from considerable experience in this area. investor
preferences and other forces continue to push
market participants of all stripes to reduce
their asset-liability mismatches. and new
economic actors arrive while old ones depart. And that’s a useful property. and we do not expect regulators to
be able to implement such a regime (at least. the portfolio manager can gain exposure to many risks without much penalty as
long as the risks of this one historical scenario
are avoided. say. July 21.This model is both
specific and random.
Subjective and broad-based risk management
is difficult.
To summarize our concerns about stress
testing:
• The next crisis is unlikely to resemble the
last crisis even in broad terms. that means that the next liquidation crisis may have less of a “financing is
going away forever” feel to it than did 2008.
Even more worrisome for the “2008”
stress test.With such a model in
place. which
is important as well. the results of
such exercises are not all that meaningful and
are reasonably different from what we would
predict would happen in the “average” crash
of that type.

futures and options
will always have buyers and sellers. E.
Each financial crisis is in some sense
unique and therefore unprecedented.With
everyone nibbling away at the same limited
set of market inefficiencies. and more ominously.
Favoring strategies that did well in 2008
on the assumption that they will also do
well in the next crisis. That is.E. a common thread does tend to run through most
financial crises: liquidity.This has made such products
much more expensive and reduced their
expected benefits in a liquidity crisis. and swaps. but there
is a tension between two of the mantras
that investors have often repeated since
then: “We need to commit ourselves now
to actions that would have helped during
the crisis” — for example. No assurances can be given that any aims. creating a vicious cycle.
Past performance should not be considered indicative of future performance. Instead. if we all learn the same specific
lessons from 2008. and we are not
the only ones worried about the next crisis. this “fishing in
the same pond” phenomenon necessarily
limits the opportunity set for investors. the D.
These behaviors may stem from a collective action problem.
••
Max Stone is a managing director and a member of
the executive committee at the D. Please note also the date of the document as the information contained in it has not been updated for any information that may have changed.We worry that this
not only increases the risk exposure of investors in those products but also threatens the
health of the financial system more generally. or the solicitation of an offer to buy.” We see well-intentioned
investors overemphasizing the first lesson
at the expense of the second.
and it’s much easier to move asset prices. We’re
also worried that investors have become
excessively partial to products that are
viewed mostly as antidotes to the last crisis
but may result in unexpected bad outcomes
given collective action dynamics that are
overlooked or not well understood. the very thing the quest for
liquidity is seeking to avoid. which
history tells us is certain to come. and/or opinions discussed in the document and makes no representation as to
their accuracy or adequacy. run stress tests
based on 2008 — and “We need to avoid
crowded trades.
Reprinted from the May 2011 issue of Institutional Investor Magazine.
By way of example. All rights reserved. however.
and the market will move against them.
THE NEXT FINANCIAL CRISIS will
necessarily differ from the last one because
the world will change to avoid the major
problems of the recent past.
One inherent property of liquidity crises
in particular is that crowded trades will be
punished. A trade
is crowded when a group of similar investors becomes concentrated on one side.
Allocating predominantly to liquid
assets and strategies.
a global investment and technology development
firm headquartered in NewYork. it’s possible
that this search for liquidity has perversely
increased the likelihood of another 2008style blowup. Furthermore.m ay 2 0 1 1
institutional investor
4 85 86 87 88 89 90 91 92 93 94 95 96 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46
asset management
relationship between individual portfolios
and a broad range of constraints and evolving market conditions. He has oversight responsibility for the investor relations and external affairs
groups and participates in the development of
the firm’s overall business strategy. And we are not the only ones who
worry about these developments. perhaps because they have overextended themselves from a risk perspective or
relied on unstable leverage (or because they
have used stop losses).He jointly supervises the firm’s worldwide asset management
businesses. the liquidity
they end up providing may be disappointing. Trey Beck is a managing director at the
D. E. at a minimum. and/or goals described in the
document will be realized or that the activities described in the document did or will continue at all or in the same manner as they were conducted during the period covered by the document. and the financial
damage will be concentrated in other areas.
.
just as many of the most-liquid products
were tapped first in 2008.The precipitating events will likely differ.
there are no easy solutions. all the while believing they’re independent actors. making them more
crowded and likely to perform worse in the
next liquidity crisis because of their popularity as a hedge.
But ironically.
It’s genuinely hard to understand in
advance which trades or strategies are
crowded. Every cash-funded asset is owned
by someone. there will
be an imbalance between buyers and sellers. we probably have learned
nothing at all. and for at least two reasons.The
consequences of a trade being crowded are
greater when this group of similar investors is
unsteady.Daniel Michalow is a senior vice
president at the D.
For crowded trades in which investors might
need to trade in a similar direction. E. Consequently.
And importantly. it’s hard to
account for the behavior of other investors
in one’s own decision making. But worry
about them we do. beliefs.Shaw group and a member
of its macro trading group. Shaw group. with a particular focus on its macro
trading activities. markets become thin. expectations. we’re concerned that investors are so heavily focused on avoiding the
bad outcomes associated with 2008 that they
have piled into crowded trades that at best
could dampen returns and at worst could
provide a fulcrum for the next crisis.The
imbalance between buyers and sellers will
reduce liquidity. Of course. Copyright 2011 by Institutional Investor Magazine.where he contributes to
the generation of investment ideas across a number
of asset classes and to overall portfolio construction. returns will tend
to erode and disappoint investors who have
not factored this into their investment decision making.
In summary.
and 2008 reinforced the lesson.
Disclaimer: The attached document is provided for your information only and does not constitute investment advice or convey an offer to sell. consider the following
investor behaviors:
Collectively bidding up tail-risk hedging products. And
yet investors and traders must learn from
previous crises even if the exact lessons will
not perfectly apply to the next crash.
Investors tend to understand all of this.
In a liquidity crisis. This has resulted
in more capital being allocated to strategies
like managed futures. Financial products
that offer cosmetically investor-friendly
liquidity terms have attracted disproportionate capital since 2008 and thus have become
more crowded.The authors
thank their colleague ErikYesson for his meaningful
assistance in the preparation of this article.The ultraliquid
investment strategies and products so popular these days are likely to be the first place
investors will go to access liquidity in a crisis. Shaw group. Shaw group does not endorse any information.
Second. assumptions. First.
investors study recent events. any securities
or other financial products.
Despite these deviations. Only later do they realize
that they all made the same trade. positioning will differ. draw similar
conclusions and then decide upon similar
actions.